Foreign Exchange is when we deal on the global level means the globalization of the firm or business. In the 21st century it is very much essential for each and every business to expand on the global level. The decisions of companies depend on the risk and returns. Due to the differences in the tax structures, exchange rates, policies, interest rates, accounting principles and practices these decisions are very much complicated for the companies. The various benefits to the companies are:-
Ø Increase market for the customers
Ø Availability of labour
Ø Availability of high-quality material
Ø Reduces cost of the production
Ø Technology up gradation Etc.
With this exposure, so many risks are also associated which are faced by every type of business and to reduce these risks businesses have to do risk management because business will accomplish all the goals and objectives with the maximum profit by following the key formula for success i.e. minimum risk and maximum return.
Objectives of Foreign exchange:-
ü Take competitive advantage
ü Reduce shareholders risk
ü Increase profit and wealth
Objectives of risk management:-
ü To minimize the risk
ü For maximum utilization of resources
ü To improve the effectiveness and efficiency
ü Use as a planning tool
ü Control cost and activities
We have to understand some basic terminologies before understanding about the foreign exchange exposure and risk management. These are as follows:-
1) Exchange rate:- exchange rate refers to the value of the currency of a country in terms of the value of the currency of another country. In other words, the value on which one nation’s currency can be exchanged against another nation’s currency. For Ex. The higher the exchange rate for one dollar in terms of rupee, the lower the relative value of the rupee which is expressed as $1=?65.
2) Spot rate:- The rate which changes very frequently because of the factors, the current market value and the future expected price of the security and non-perishable commodity. The current market value which is acceptable to both the parties’ buyer and seller to perform the transaction.
3) Forward rate:- The forward rate is the rate at which the buyer and seller agreed to exchange the currency on a future date. In the other sense, we can say the rate or value on which the value of one currency exchanged for another currency on a future date. It is used to determine the price of future contracts. It can be higher or lower than the spot rate. If higher then spot means on premium and if lower means on discount.
4) Cross rate:- The price of any currency other than home currency. Cross rate refers to the rate of two nation’s currencies like Euro and Rupee expressed or computed in reference to third nation currency like the dollar. Generally, US dollar is used.
5) LIBOR:- ” The London Inter-Bank Offered Rate (LIBOR) is the world’s most widely used benchmark for short-term interest rates. It’s important because it is the rate at which the world’s most preferred borrowers are able to borrow money. It is also the rate upon which rates for less preferred borrowers are based. For example, a multinational corporation with a very good credit rating may be able to borrow money for one year at LIBOR plus four or five points. The LIBOR is derived from a filtered average of the world’s most creditworthy banks’ interbank deposit rates for larger loans with maturities between overnight and one full year. Countries that rely on the LIBOR for a reference rate include the United States, Canada, Switzerland and the U.K.”
6) Hedging:- Hedging refers to the investments to reduce the various types of risk from the foreign exchange. The different ways adopted by the companies to make their investment safe and minimize their risk.
Bars University journal vol. V no. 2, 2008 By Sathya Swaroop Debasish Department of management studies Fakir Mohan University, Vyasa Vihar, Balasore, Orissa studies and presented about the Foreign Exchange Risk Management Practices- A study in India scenario and the finding revealed about the companies hedge and the derivatives used by companies.
CA. Jalaj Chhaya , the chartered accountant journal volume 61, no. 5, November 2012 explained in detail about the various risk and there hedging for the best returns.
Laurent L Jacque and review article March 1981 subjected management of foreign exchange risk and revealed about the forecasting of exchange rates and measuring exposures in exchange.
In the research, all the data used is secondary like already published papers, articles, books and the research was an exploratory research, tried to explore about the various exposures in foreign exchange and hedging tools to know which techniques will be more suitable in different types of exposures.
Objectives of the study:-
1) To understand the various types of risks in foreign exchange.
2) To understand the techniques of risk management.
3) To identify the most suitable tools for different types of exposures in the foreign exchange.
The whole study is based on secondary data which is a big limitation of my study. This is a review paper, presents the opinion of the author and cannot be fully journalized.
Types of Foreign Exchange Exposure / Risk
1) Foreign Exchange Rate Risk
It is also called as currency fluctuation risk. The risk of difference is the value of assets and liabilities or other operating incomes in comparison to the domestic currency value due to fluctuation in the exchange rate between the nations.
For example, if ABC Indian firm has taken a loan from an American bank. At the time of repayment if the dollar is stronger than rupee firm has to pay the extra money and if weaker then rupee then have to pay less amount and will save the extra amount.
2) Interest Rate Risk
When the interest rate is fixed at the starting and remains same till end called fixed rate instrument. But now a days flexible interest rate instruments are more popular in which the rate is associated with any other factor for the benchmark. The interest rate generates the following exposures for the firms:-
1) Translation Exposure:-
Translation exposure relates to the change in accounting income and balance sheet statements caused by the changes in exchange rates. It can be understood that this risk is associated with only those organizations which deal in foreign currency or have foreign assets on their balance sheet. This is a serious constraint for the global companies. Companies purchase swaps or deals through future contracts to minimize this risk.
The companies have foreign assets and liabilities on their balance sheet have to translate the value of those assets and liabilities in domestic currency from the foreign currency. At that time due to the difference in the exchange rates between the currencies the value of the assets and liabilities changes cause as a risk for the company in showing actual value in a balance sheet. In India Accounting Standard 11 for the effect of the change in foreign exchange rates is followed by the companies.
2) Transaction Exposure:-
The risk in the transactions. The risk because of the time gap between the entering into the transaction and the completing the transaction because more the time gap means more chances of fluctuation in the exchange rates. Higher the time gap, higher the fluctuation and higher the risk.
For example, if a firm purchase material from the US priced $50,000 the payment will be done after receiving the material which takes 45 days. At the time of contract $1= ?35.00. Indian have to pay ?35 * 50,000 = ?17,50,00 . If at the end of 30 days $1 = ?40.00 then Indian have to pay ?40 * 50,000 = ?20,00,000 means ?2,50,000 extra becomes loss for the Indian party.
3) Operating Exposure:-
This risk is also referred as Economical Risk. It refers to the increase or decrease in the companies cash flow due to the unexpected change in the exchange rate. This exposure is not related to any single transaction such as transactional risk, This is related to the entire investment decision as a whole. It can effect the firm’s competitive position by changing the value of inputs and outputs of the business. This risk comes when the company is involved in import or export. Economic and transactional risk can affect the profitability as well as the share prices of the business so the management of these are very much required by the companies.
Methods of Hedging
v Forward Contracts:- The contract between two parties to buy and sell at a specified date and price. This is an over the counter contract which is non-standardized. This type of contract doesn’t form any type of legal obligations towards the parties.
v Future contract:- These are also same as the forward contracts between the two parties to buy and sell at a specified date and price. But this is a standardized contract which creates legal obligations towards the parties. The price of the contract depends on the present price and the future expected price.
v Netting/offsetting:- Matching the maturity dates and currencies of sums receivable and payable between the countries for offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to fluctuate.
For example, if an Indian firm has to pay ?100,000 to US firm and Receive $150,000 form the same firm on the same due date then will receive $ 50,000 for full settlement is called netting and offsetting.
v Leading and Lagging:- Companies deals on international level attempts to achieve to have their assets in a strong currency and liabilities in a weak currency. This may be achieved with the help of the technique known as ‘ leading and lagging’ by adjusting the timing of receipts and payments. Leading is taking the lead to collect from foreign currency designated debtors and initiate to pay creditor before they are due.
Lagging is delaying receipts from the foreign currency designated receivables whose currency are likely to appreciate and delaying payables whose currencies are likely to depreciate.
v Currency invoice:- Invoicing in home currency is an ideal method of hedging. This method enables the companies to know the precise amount, it is likely to receive from sales and the exact amount it is to pay for the purchase. By this, the foreign exchange risk is completely eliminated.
v Option:- In the situation when the company gets confused between hedging of inflow and outflow this option solves the problem. There are two types of option:-
l Put Option:- In this the buyer gets the right, but not the obligation, to sell a specified no. of foreign currency units to the option seller at a fixed price up to the option’s expiration date.
l Call Option:- This option is valuable when a firm has offered to buy a foreign asset, such as another firm, at a fixed foreign currency price but is uncertain whether its bid will be accepted.
v Swap:- A foreign currency contract in which the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. At maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end-up with their original currencies.
Implication of Hedging Tools:-
On the various types of exposures, we can apply different types of hedging techniques. In the Translation Exposure, we can hedge the exchange with the help of forward contract, netting and leading & lagging. In Transaction Exposure we may use currency swaps, leading & lagging, forward contracts and option etc. to hedge the exchange on an international level. In the same way, in operating exposure, we can use currency invoice, option, and swap to minimize the risk.
On the basis of study, we can conclude that the emerging hedging tools are helping to the companies in risk management up-to a large extent. The companies are using so many techniques for the hedging purpose but the most effective and useful tools in the today’s time are option and swap. These two helps the firms in getting the competitive advantage in the market by the management of risk in a proper and efficient way. Firms are using these tools more and more and getting the benefits in an overall manner. It is expected that in next decades the use of these techniques will increase widely and bring a lot of changes in the conditions which will affect the economies of countries in a positive way as well beneficial for the users of the tools in each aspect.